Continuous Workout Mortgages: Efficient Pricing and Systemic Implications

65 Pages Posted: 20 Dec 2017 Last revised: 16 Mar 2018

See all articles by Robert J. Shiller

Robert J. Shiller

Yale University - Cowles Foundation; National Bureau of Economic Research (NBER); Yale University - International Center for Finance

Rafal M. Wojakowski

University of Surrey; Lancaster University - Management School

Muhammed Shahid Ebrahim

Durham Business School

Mark B. Shackleton

Lancaster University - Department of Accounting and Finance

Date Written: December 8, 2017

Abstract

This paper studies the Continuous Workout Mortgage (CWM), a two in one product: a fixed rate home loan coupled with negative equity insurance, to advocate its viability in mitigating financial fragility. In order to tackle the many issues that CWMs embrace, we perform a range of tasks. We optimally price CWMs and take a systemic market-based approach, stipulating that mortgage values and payments should be linked to housing prices and adjusted downward to prevent negative equity. We illustrate that amortizing CWMs can be the efficient home financing choice for many households. We price CWMs as American option style, defaulting debt in conjunction with prepayment within a continuous time, analytic framework. We introduce random prepayments via the intensity approach of Jarrow and Turnbull (1995). We also model the optimal embedded option to default whose exercise is motivated by decreasing random house prices. We adapt the Barone-Adesi and Whaley (1987) (BAW) approach to work within amortizing mortgage context. We derive new closed-form and new analytical approximation methodologies which apply both for pricing CWMs, as well as for pricing the standard US 30-year Fixed Rate Mortgage (FRM).

Keywords: Negative Equity, House Price Index Indexation, Repayment Mortgage, Insurance, Embedded Option to Default, Prepayment Intensity

JEL Classification: C63, D11, D14, D92, G13, G21, R31

Suggested Citation

Shiller, Robert J. and Wojakowski, Rafal M. and Ebrahim, Muhammed Shahid and Shackleton, Mark B., Continuous Workout Mortgages: Efficient Pricing and Systemic Implications (December 8, 2017). Cowles Foundation Discussion Paper No. 2116. Available at SSRN: https://ssrn.com/abstract=3090552 or http://dx.doi.org/10.2139/ssrn.3090552

Robert J. Shiller (Contact Author)

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States
203-432-3708 (Phone)
203-432-6167 (Fax)

HOME PAGE: http://www.econ.yale.edu/~shiller/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States
203-432-3708 (Phone)

Yale University - International Center for Finance ( email )

Box 208200
New Haven, CT 06520
United States
203-432-3708 (Phone)
203-432-6167 (Fax)

Rafal M. Wojakowski

University of Surrey ( email )

Faculty of Business, Economics and Law
The Surrey Business School
Guildford, Surrey GU2 7XH
United Kingdom
+44 1483 683477 (Phone)

HOME PAGE: http://www.surrey.ac.uk/sbs/people/rafal_wojakowski/index.htm

Lancaster University - Management School ( email )

Lancaster, LA1 4YX
United Kingdom
+44 (1524) 593630 (Phone)
(01524) 847321 (Fax)

HOME PAGE: http://www.lums.lancs.ac.uk/profiles/rafal-wojakowski/

Muhammed Shahid Ebrahim

Durham Business School ( email )

Mill Hill Lane
Durham, Durham DH1 3LB
United Kingdom

Mark B. Shackleton

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
44 1524 594131 (Phone)
44 1524 847321 (Fax)

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